US Supreme Court lets Altera decision stand: implications for cost sharing and stock options

By Dr. J. Harold McClure, New York, NY

The US Supreme Court on Monday announced that it would not review the Ninth Circuit panel decision in the Altera case.

Thus, the Supreme Court left standing a June 7, 2019, Ninth Circuit decision that upheld the validity of US cost sharing regulations. These regulations require related entities to share the cost of employee stock compensation in a cost-sharing arrangement for it to be considered a tax-favored qualified cost sharing arrangement (QCSA).

As will be shown below, the dollar amounts at stake for Altera and the US Treasury in this court battle were massive. While Altera lost its case, Facebook and other multinationals are in a similar position. It is therefore expected that the IRS and taxpayers will continue to litigate the issue of inclusion versus exclusion of stock based compensation in courts not bound by the Ninth Circuit.

Cost sharing agreements and stock options

Many multinationals, including Altera, Amazon, Facebook, Google, and Microsoft, have entered into cost sharing agreements with their affiliates located in low tax jurisdictions to share intangible development costs.

These multinationals also compensate both their R&D and marketing personnel with a mix of compensation that includes a significant amount of employee stock option compensation.

From 1992 to 2006, multinationals resisted the attempts by the Financial Accounting Standards Board to include the time-of-grant expected cost of employee stock options in their income statements.

This inclusion, however, has been mandated under FAS 123 since 2006.

The IRS and multinationals, including Altera, also dispute whether employee stock option compensation should be included in a cost sharing agreement’s shared intangible development costs. Both the taxpayer and the IRS argue that the arm’s length standard supports their position. As will be seen, the implications of this distinction to Altera, other multinationals, and the US Treasury, are huge.

Amounts at stake for Altera

Altera designs, manufactures, and markets programmable logic devices. Altera was acquired by Intel in 2015. During the three years from 2012 to 2014, its financials indicate annual sales were approximately $1.8 billion, with 82 percent of those sales being international sales.

Cost of production was 32 percent of sales; selling costs, including both wage and employee stock option compensation, were 17 percent of sales; and R&D costs, including wage and employee stock option compensation, were 21 percent of sales.

Consolidated profits were, therefore, 30 percent of sales.

Altera’s 10-K filing noted that employee stock option compensation represented $90 million per year, with this compensation evenly divided between compensation for R&D personnel and marketing personnel.

If employee stock option compensation were shared between the US parent and the Cayman affiliate, then the parent would receive 18 percent of consolidated profits or $97.2 million, while the Cayman affiliate would receive $442.8 million in profits.

The table shows this allocation of income as the IRS position.

Altera asserted that the Cayman affiliate should not share in employee stock option compensation under the arm’s length standard.

The table shows that this position would reduce US income to only $23.3 million, while income for the Cayman affiliate would be $516.6 million.

Alternative Income Statements for Altera

2012-2014		IRS position		Taxpayer position
Millions	Total	US	Foreign	US	Foreign
Sales	$1,800.00	$324.00	$1,476.00	$324.00	$1,476.00
Production costs	$576.00	$103.68	$472.32	$103.68	$472.32
Selling-wage	$261.00	$46.98	$214.02	$46.98	$214.02
Selling-employee stock option	$45.00	$8.10	$36.90	$45.00	$0.00
R&D-wage	$333.00	$59.94	$273.06	$59.94	$273.06
R&D-employee stock option	$45.00	$8.10	$36.90	$45.00	$0.00
Profits	$540.00	$97.20	$442.80	$23.40	$516.60

Thus, it can be seen that the issue of exclusion versus inclusion of employee stock option compensation has a dramatic impact on the allocation of consolidated profits for Altera, and likely also other high-tech companies that have similar cost sharing arrangements.

Given the fact these cost sharing partners are generally located in low tax jurisdictions, whether the IRS position prevails is an important issue for high-tech multinationals.

Facebook and other MNEs

Facebook, which is already in litigation with the IRS over other transfer pricing issues, is just one example of another MNE affected by the exclusion versus inclusion of employee stock option compensation in a cost sharing arrangement.

For the fiscal year ended December 31, 2019, Facebook’s sales were $70.7, and its total R&D expenses, including employee stock option compensation, represented 19.2 percent of sales.

Facebook also incurred $4.8 billion in employee stock option compensation, with $3.5 billion of that compensation related to R&D expenses.

Facebook will owe millions of dollars of additional tax to the US Treasury if a portion of this compensation is deemed to be borne by Facebook’s foreign cost sharing affiliate.

Arm’s length principle

The million-dollar question is whether the arm’s length standard supports the exclusion of employee stock option compensation or whether it supports the IRS position.

A primary argument made by taxpayers such as Altera was that the IRS had failed to identify any third party contracts where the parties explicitly agreed to share employee stock option compensation.

The Altera Appeals court noted this taxpayer argument but rejected it:

Altera’s argument is founded on its belief that an arm’s length analysis always must be method-oriented, and rooted in actual transactional analysis. Altera also argues that Treasury did not adequately support its position that employee stock compensation is a cost, asserting that Treasury wrongfully ignored evidence that companies do not factor stock-based compensation into their pricing decisions. … Though commentators presented evidence of some transactions in which stock-based compensation was not a cost, this evidence provided little guidance because it did not concern parties to a QCSA developing high-profit intangibles. This out-of-context data did not require a different decision. In the absence of applicable evidence, Treasury’s analysis provides a logical explanation of how treating stock-based compensation as a cost leads to arm’s length results.

While this argument was dismissed by the IRS and was critiqued by the Altera Appeals court in its decision as not being that demonstrative, it is a valid argument that third-party service recipients would be reluctant to share in the risk inherent in the issuance of employee stock option compensation.

The court also explained the arguments for exclusion versus inclusion of employee stock option compensation in shared intangible development costs: 

In order for a QCSA to reach an arm’s length result consistent with legislative intent, the QCSA must reflect all relevant costs, including such critical elements of cost as the cost of compensating employees for providing services related to the development of the intangibles pursuant to the QCSA. Treasury and the IRS do not believe that there is any basis for distinguishing between stock-based compensation and other forms of compensation in this context. Treasury and the IRS do not agree with the comments that assert that taking stock-based compensation into account in the QCSA context would be inconsistent with the arm’s length standard in the absence of evidence that parties at arm’s length take stock-based compensation into account in similar circumstances. The uncontrolled transactions cited by commentators do not share enough characteristics of QCSAs involving the development of high-profit intangibles to establish that parties at arm’s length would not take stock options into account in the context of an arrangement similar to a QCSA.

Altera and other multinationals have offered a litany of claims in their attempts to exclude employee stock option compensation.

An early argument was that employee stock options did not represent an actual cost, but this view was rejected in the accounting debate that led to FAS 123.

While the Appeals court noted the taxpayer’s argument that the IRS failed to present evidence that companies do not factor stock-based compensation into their pricing decisions, its decision was not swayed by this position. Economists often estimate market price based on economic costs, which includes total compensation regardless of the form of this compensation.

Time-of-grant versus time-of-exercise value

This legitimate concern is relevant if the IRS insists on the sharing of actual costs with respect to employee stock option compensation, which would be the case if employee stock option compensation were based on time-of exercise-valuation under section 83 of the US tax code, which addresses the taxation for individuals who have received compensation in the form of employee stock options.

The IRS position fares better if it were based on time-of-grant valuation under FAS 123, which is the expected value of employee stock option compensation at time-of-grant.  

Only time will tell if this Appeals decision will become the prevailing view and high-tech multinationals with cost sharing arrangements will need to measure the expected costs of intangible development costs inclusive of employee stock option compensation.

— Dr. J. Harold McClure is an economist based in New York, NY.